How to Evaluate Investment Banking Stocks

Looking beyond the traditional P/E ratio, there are several other key metrics investors should know before trying to evaluate an investment bank. Here's an explanation of how to interpret investment banks' price-to-tangible book value, return on equity, and efficiency ratios.

A full transcript follows the video.

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This video was recorded on Dec. 11, 2017.

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Michael Douglass: Let's talk about part two of the banking framework, which is, how expensive is the bank? Of course, the two things you want to look at here are price to tangible book value and price to earnings.

Matt Frankel: Right. These are both similar in both respects. Price to tangible book value, Goldman (NYSE: GS) comes in right around 1.4. Morgan Stanley (NYSE: MS) is a little more expensive at about 1.6. Price to earnings, these both actually sounds really cheap compared to the rest of the S&P. Goldman is about 13 times earnings; Morgan Stanley is about 14.5. Morgan Stanley is a little bit more on the expensive side just by those two metrics. But again, any two metrics don't really tell you the full story, so let's go deeper.

Douglass: Absolutely. So, part three, what is the bank's earnings power? Return on equity, I tend to like to look at both the last quarter and the trailing 12 months, just because, one quarter to another, there could be some weird volatility. Trailing 12 months usually gets you some sense of the longer-term differences, if any.

Frankel: Right. In this case, generally, for any kind of bank, you want to look for a return of equity of about 10%. That's generally what they need to really cover their cost of capital and make money for shareholders. In Goldman's case, they're almost at 10%. They were 9.8% both the last quarter and the trailing 12 months. Morgan Stanley was 8.9% for last quarter and 9.1% for the trailing 12 months. So, the way I would interpret that, not too big of a difference, they're both almost in line with industry benchmarks but not quite.

Douglass: Right. Of course, net interest margin isn't going to be all that helpful in this case, since so little of their money comes from loans. So let's hop on right over to efficiency ratios, which again, as a quick refresher, are essentially a sign of how good the bank is at controlling its own costs.

Frankel: Right. Efficiency ratios, it's actually a really easy metric to calculate. All you have to do is take the bank's non-interest expense and divide it by its total revenue for whatever period of time you're looking at. Lower is better, because you're essentially seeing how much a bank is spending for every dollar in revenue they're making. In Goldman's case, for the last quarter, it was about 64% efficiency ratio, meaning that for every dollar in revenue they generated, they spent about $0.64, not including interest, which as Michael said, isn't a very big factor here. Morgan Stanley is actually a little less efficient. They're about 73% for the last quarter, so they spent $0.73 for every dollar in revenue they generated. Which could explain the discrepancy in return on equity that we just talked about.

Douglass: Right. The fourth piece is, how much risk is the company, or in this case, are the companies, taking on to achieve those earnings. Really, non-performing loans is usually useful, not terribly useful here, since such a small percentage of both banks come from loans. Again, this is just highlighting how you have to adapt a framework to whichever bank you're looking at. But assets over equity is about 11 in both cases. So, what that means is, they're both, all things considered, about correctly leveraged.

Frankel: Right. With investment banks also, as far as risk goes, it's important to mention that they have a few different lines of business, some of which kind of complement each other. Investment banking consists of M&A advisory, equity, and debt underwriting. Then you have things like trading and wealth management, which really offset each other depending on what the economy is doing. Right now, trading revenue is absolutely terrible. It's actually on the fixed-income side of things. And the reason for that is, the economy in the market are doing so well and volatility has been so low that trading volume has just fallen off the cliff.

The flip side of that is, things like wealth management are performing extremely well because the way they make money on this is fee-based, and if the market keeps going up and up, assets under management for both these firms keeps going up and up and up, and they're going to be making more fee income. So that's what I mean by one tends to offset the other.

On the other side, if wealth management revenue went down because the market was performing terribly, the trading volume could spike; if volatility spikes, then trading volume would get a lot higher and then start generating more money that way. So these banks are kind of, in a way, set up to make money no matter what the market is doing, which is definitely a point to note if you're looking at investment banks.

Douglass: Particularly in terms of thinking about the risk, because people always talk about wanting recession-proof businesses. Of course, I'm not aware of any recession-proof businesses, because they all are affected by recession in some way, shape, or form. But the fact of the matter is, these offsets really do help reduce that risk.